Description

Note: I recommend you read phn19’s prior write-up on this name. I acknowledge leveraging his work and that the thesis is similar. However, there have been material developments and price volatility since the write-up, and I think the opportunity worthy of a new post.

Summary Investment Thesis:

Owens & Minor (“OMI” or the “Company”) manufactures and distributes various types of hospital consumables that are low margin and commoditized in nature. Given (i) OMI’s ability to alleviate near-term bankruptcy concerns, (ii) the market capitalizing COVID-related PPE earnings, and (iii) a short squeeze (short interest peaked at ~16%), the Company’s stock has significantly rebounded from its lows. Specifically, OMI’s stock is up ~480% from its 5-year low of $2.47 (7/22/19) and ~250%  from its COVID low of $4.12 (3/12/20), resulting in a ~$900mm market cap today. However, I believe that the market is wrong in its assessment of a fundamental change / inflection point in OMI’s long-term business prospects, and the Company will remain a structurally challenged player in a fiercely competitive market. As a result, the shares are an attractive short right now, with the potential for a $0 over time. However, I do not advocate for a short position of their ’24 Bonds given high likelihood of a refinancing.

Background / History:

Owens & Minor is a 135+ year old company based in Richmond, Virginia. The Company began with a retail drugstore presence and evolved into supplying independent drugstores. OMI started its modern history of being a med-surg distributor in 1966 with the purchase of J&J Hospital Supply. Growth continued throughout the ‘70s and late ‘80s, with Gil Minor III (grandson of the founder) expanding the med-surg distribution business and moving away from drug wholesaling. The Company IPO’d in 1983, and became a Fortune 500 business and one of the largest employers in the greater Richmond area. Post-IPO, OMI focused on growing med-surg distribution (now the core business), notably acquiring McKesson Medical-Surgical in 2006 and expanding internationally to Europe with the purchase of Movianto in 2012. From its IPO to 2014, OMI’s stock price compounded at a ~10% CAGR, while paying out a steady and increasing dividend stream. Although there were modest pricing pressures, OMI was able to benefit from broader macro trends (e.g. aging demographic, increased hospital spend) and consolidation in the industry. The Company developed a reputation for being a steady grower with a healthy dividend payout, whose business was immune to any disruption or recessionary environment (i.e. what could be safer than distributing supplies to a hospital?). However, performance began to deteriorate within the core business (now known as Global Solutions) during the mid-2010s which led to a dividend cut and the current situation.

Global Solutions:

Acute Care Distribution:

The Global Solutions segment consists almost entirely of OMI’s legacy core business – distribution of medical-surgical supplies to acute care facilities in the U.S. OMI distributes products such as surgical masks, gowns, gloves, sterilization wraps, etc. from third party suppliers (e.g. Johnson & Johnson) and its own proprietary products. The Company is one of the largest players in the space, serving 1,400+ branded manufacturers and 4,000+ healthcare providers, and boasts delivery times of under 4 hours to 90% of U.S. hospitals. Global Solutions signs multi-year contracts with customers under a cost-plus model – typically pricing its services at cost plus a low single digit % mark up. OMI prides itself on being supplier agnostic (i.e. indifferent to distributing a J&J product vs OMI proprietary product) and highly flexible re: delivery schedules and truckload sizes. Of note, prior to its 2018 purchase of Halyard’s S&IP business (details below), OMI did not want to compete with its suppliers by selling proprietary / private label products. The Company has historically been thought of as the “distributor of choice” for suppliers given OMI wouldn’t directly compete with their own private label products.

Global Solutions competes with two other companies, Cardinal Health (~$20bn enterprise value) and Medline (private / family owned), who altogether control 90-95% of the acute care distribution market. Market share breakdown is as follows: Cardinal Health (~40%), OMI (~30%), Medline (20-25%), and smaller providers like Concordance with the remaining share. Despite it being an oligopolistic market, there have been significant pricing pressures, mainly due to the difference in business models between OMI and its two competitors. First and foremost, Medline is a products-focused company and entered distribution as a way to vertically integrate. Medline began this initiative 10-15 years ago when distribution mark-ups were in the low double digits versus OMI’s low single digit mark-up today. Most worrying for OMI, Medline in recent years has begun to offer their distribution services for free (or close to free), as they make their margin on increased purchases of their own products. Although Cardinal was historically a distribution company as well, it has aggressively acquired products companies to compete with Medline and now derives ~40% of its sales from proprietary products. Prior to OMI’s acquisition of Halyard’s S&IP business, the Company derived <10% of its sales from its own products, effectively giving the Company no way to compete on price with its two largest competitors. OMI began to lose business once contracts came up for renewal, most notably losing its $525mm contract with Kaiser Permanente to Cardinal Health (announced in 2016).

Competitive pressures aside, the customer landscape has posed increasing problems for OMI and acute care distributors overall. Post-ACA, there has been significant consolidation amongst providers and payors. OMI is now selling into larger customers that have increased leverage whenever a contract renewal is negotiated. Additionally, OMI’s customers face reimbursement pressure from both Medicare and Commercial payors, and their already low margin profile incentivizes hospitals to procure supplies as cheaply as possible. Hospital reimbursement doesn’t appear to be improving post-COVID, with the Hospital Insurance Trust Fund (which finances Medicare Part A) forecast to be insolvent in 4 years. Likewise, Commercial rates will likely not improve as payors continue to gain scale and there is a higher uninsured population post-COVID. Given these dynamics, price is the main driver of winning business from hospitals and OMI cannot compete with Medline and Cardinal.

In 2017, former CEO Cody Phipps implemented a restructuring plan dubbed “Rapid Business Transformation” that was supposed to result in $100-150mm of annual cost savings. In practice, cost cuts led to a significant drop-off in fill levels and customer service, which only exacerbated the issue of OMI being priced at a premium to its peers. The new management team has done a commendable job at returning fill rates and order accuracy to adequate levels, but that is merely table stakes for a distribution business that charges a premium price.

As Global Solutions’ top-line profile has declined, segment profit has been materially impacted given the fixed cost nature of running massive distribution centers and warehouses. From 2016 to 2019, Global Solutions segment profit margin compressed ~80bps to reach 1%, which represents a material $ amount given the ~$8bn top-line. Specifically, Global Solutions has lost $85mm of segment profit during this time period in a business that historically did $250-$350mm of total EBITDA. Q2’20 Segment margins of (0.65)% are a good example of what top-line declines in a 1% margin business with high fixed costs can look like. Overall, the acute care distribution business will remain challenged, with margins at or below 1% for the foreseeable future. However, contracts in this business are multi-year and can take a long time to transition to a new distributor. Thus, I expect a slow and steady top-line decline vs. an immediate drop off.

Non-Acute Care Distribution:

Global Solutions has one bright spot called Byram Healthcare. Byram is a home health distributor of diabetes, ostomy, wound care, and other products. It was acquired from Mediq in 2017 for $380mm and had a $450mm top-line at the time. Channel checks have indicated that this business has been largely left alone (i.e. headquarters is standalone in White Plains, NY), and has grown at a high single digit / low double digit top-line. Byram benefits from a recurring customer base, increased volumes to the home care setting, and likely has a far superior margin profile vs. OMI’s other businesses. Also, Byram has several barriers to entry around home delivery logistics and payor contracting which make it more attractive than acute care distribution. My estimates are that Byram contributes $550-$600mm revenue and $55-$60mm of EBITDA today (~10% margins assumed), implying that the core distribution business is less profitable than the reported segment profit margin of 1%. The other non-acute care distribution businesses include various solutions for suppliers / manufacturers and a Kits & Trays business, but it’s unclear that any of these are material.

Global Products:

As OMI continually lost business to Medline and Cardinal, they logically wanted to grow their portfolio of proprietary / private label products. During 2017, Halyard Health (now re-branded as Avanos Medical) was looking to divest its Surgical & Infection Prevention (“S&IP”) segment to become a faster growth / higher margin, pure-play medical device company. Former CEO Cody Phipps likely felt that he needed to aggressively build his products business in order to remain relevant, and bid ~8.5x 2017 EBITDA for S&IP ($710mm purchase price, $83mm EBITDA). In order to finance the transaction, OMI issued a new TLA/TLB and levered up to 4.7x; Due to covenants at the time, OMI had to provide its then Unsecured Notes with the same Security package as the new Term Loans. While the acquisition logic was sound in my opinion, OMI unfortunately paid far too high of a price for a portfolio of commoditized products subject to fluctuations in input costs.

The S&IP portfolio consisted of Halyard branded products that were ranked #1 or #2 in their respective categories and that OMI already distributed (e.g. drapes, gowns, gloves, sterilizations wraps, etc.). Channel checks have shown that Halyard does have strong brand recognition amongst physicians (even despite a negative 60 Minutes expose in 2016 on faulty equipment provided during Ebola) and that they have done a decent job on certain product refreshes. However, the products are still largely commoditized and face pricing pressures, especially as Medline, Cardinal, and others have invested in upgrading their own portfolios. Aside from physician preference items which are typically reserved for more impactful products (e.g. a specific type of hip implant vs. a surgical glove), physicians aren’t as involved in choosing hospital supplies as one would think. So, even if physicians prefer a Halyard glove over a Medline glove, the decision rests with the head of procurement / supplies who is most focused on the cost of an item. One former sales rep noted that when he first started in the industry, the conversation was always based on “what does the physician want?” versus today’s discussion always centers around “what money can you save me?”.

As a result, Global Products segment margins have decreased from 10% in 2016 to 4.5% in 2019. Although this segment does not have the same zero-margin risk of the distribution business, it is difficult to see a scenario where OMI is able to increase margins going forward. Thus, I expect a flat to slightly declining margin profile for the foreseeable future.

The Global Products business also has the unfortunate aspect of being exposed to volatile input costs of polypropylene and nitrile. Both products are derived from oil, and OMI will likely benefit from the lower prices experienced during late 2019 and into 2020. However, rising input costs have historically been a headwind at times, as recently as late 2018. Given these input costs are difficult to hedge and OMI does not have enough pricing power to pass along higher input costs to the customer, any volatility in raw materials can have a material impact on Global Products’ margins.

The one bright spot within the segment is that OMI has a significant U.S. based manufacturing footprint, with a main facility in North Carolina. In contrast, Medline and Cardinal mostly manufacture in Malaysia and Thailand. This has been instrumental during COVID-19, which is discussed in more detail below.

Management:

Former CEO Cody Phipps was appointed in 2015. Phipps was a former McKinsey partner who led their “Global Operations Effectiveness Practice”, and later became CEO of Essendant, a wholesaler of business products. Phipps was hired with the intent of turning around OMI’s business and changing its distribution-only strategy. While Phipps made strategic acquisitions of Halyard S&IP and Byram Healthcare, he proved to be out of touch with customers and OMI’s culture. As previously mentioned, his Rapid Business Transformation initiative led to customers receiving poor service while still paying a premium price. At the same time, Phipps tried to raise prices on OMI’s largest suppliers given he believed that they needed OMI to survive in the industry and would be largely price inelastic. As far as I can tell, this had no positive impact. The most mis-guided aspect of Phipp’s strategy was that he believed OMI had unique data and monetizing it would be key to the Company’s success. Throughout his tenure, the Company continued to struggle and he eventually was replaced in early 2019 by the current CEO, Ed Pesicka.

From day 1, Pesicka has emphasized that the Company needed to get back to its roots of operational excellence in distribution and expand its penetration of proprietary products sales. He has made good progress to date, with on-time delivery and order fill accuracy returning to 99% and Global Products increasing as a % of sales. He has picked the low-hanging fruit throughout the business, spending capex dollars on warehouse software upgrades and implementing technology already found in many distribution businesses (e.g. voice pick assistance). Additionally, he has upgraded the management team with former colleagues from Thermo Fisher. While Pesicka should be commended for improving results during his tenure, the Buffett quote of “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact” aptly applies.

Credit Documents & Recent Amendment:

OMI originally entered its Credit Agreement in July 2017 and has subsequently amended it five times. Creditors of OMI benefit from a robust set of covenants, especially compared to other credit docs in the market today. The TLB has a Gross Leverage maintenance covenant set at 7.5x, with subsequent step-downs over time. There is limited Restricted Payments capacity, and any tricks regarding investments into non-loan parties / non-guarantors is limited. Also, creditors benefit from restrictive covenants in the Revolver and Term Loan A Credit Agreements (e.g. 1.75x Interest Coverage, Annual Capex covenant). However, these can be amended without the consent of other creditors. Given the Revolver and TLA are mostly held by relationship banks, I imagine that they would be open to amending if necessary.

As the maturity date of its ’21 Notes (9/15/21) approached, OMI amended its Credit Agreement in February 2020. The most notable aspects of the amendment were as follows:

• Increased TLB Gross Leverage covenant from 7.0x to 7.5x, which then ratchets up to 7.75x for Q2’20, before stepping down to 5.75x over time

• Decreased Interest Coverage Ratio from 2.25x to 1.75x, before increasing to 2.5x over time

• Increased the Accounts Receivable Securitization Facility from $150mm to $350mm, with language re: A/R sale proceeds being used to pay down the Revolver, Term Loan A, and ’21 Notes

• Permitted the usage of Movianto Sale Proceeds (details below) to pay down the ’21 Notes

• Added in a vague debt basket which could potentially allow for uncapped Credit Agreement debt. The language allows any debt following the Pro Rata Termination Date that “serves to refinance, renew, restructure, redeem, refund or replace debt arising under this Credit Agreement and related credit documents”

• Pro Rata Termination Date: When all Revolver commitments have been terminated, all Revolver obligations and Term A Loans have been paid in full, and all LCs under the Revolver have been terminated / expired

The amendment succeeded in alleviating 2021 bankruptcy concerns given it allowed for a substantial paydown of the ’21 Notes. Existing TLA holders received a rate increase of 75bps on their existing paper. In exchange, they allowed for a loosening of covenant levels, asset sale proceeds to be directed towards the near-dated ’21 Notes, and an increase in the size of the A/R facility.

The new language around Credit Agreement Refinancing Debt was probably put in place to allow for flexibility when the ’24 Notes maturity approaches. Also, I imagine the Revolver and TLA lenders would amend to allow for A/R sale proceeds to be used to pay down the ’24 Notes if needed. Together with the thirst for yield in the market today, I imagine OMI will be able to find a way to refi their ’24 Notes or do a global refi instead.

Movianto Divestiture: Note, Movianto is a European focused 3PL that OMI acquired in 2012 and agreed to divest in 2020 for $133mm.

COVID-19 & Recent Events:

When COVID-19 initially hit, OMI’s business suffered as elective procedures were banned and hospitals volumes fell off a cliff. Its stock price fell, reaching a low of $4.12 on 3/12/20. However, the stock increased ~50% on 3/27/20 after the CEO went on Mad Money with Jim Cramer, emphasizing the domestic manufacturing footprint of the Products business and unprecedented demand for PPE. Later, on their earnings call, Management noted a Q2’20 revenue headwind of $480mm in the distribution business. However, the stock continued to creep higher as international supply chains were being disrupted and OMI had significant orders for PPE. The Company received further press / awards, producing fabric for medical gowns used in NYC hospitals, working with FEMA on distributing PPE to the hardest hit U.S. regions, and being awarded a DoD contract worth ~$30mm.

The most important announcement came on 7/21/20, when the Company revised its 2020 earnings guidance from $0.50-$0.60 EPS to $1.00-$1.20 EPS. Management highlighted that OMI is benefitting from “increased manufacturing output in response to unprecedented demand for personal protective equipment, an earlier than expected increase in elective procedures across much of the country, favorable product mix, and operating efficiencies”. The announcement caused a massive short squeeze, sending the stock up ~80% on the day. Later on their Q2’20 earnings call, Management discussed non-healthcare related demand for PPE as one of their growth avenues, and mentioned PPE demand outpacing supply multiple times.

I am not going to make an estimate on the number of PPE that OMI will produce and sell – they are already past their 5 billionth unit as of August 2020. My thesis is based on the notion that a temporary (1 year? 2 year?) increase in demand for PPE (i) should not be capitalized, or in other words OMI’s multiples should reflect ex-COVID earnings, and (ii) does not change the long-term outlook for OMI’s secularly challenged business model.

Separately, Management has emphasized their cash flow generation (defined at GAAP OCF-Capex) on almost every earnings call. However, the cash flow generation isn’t sustainable and is not high quality, as it is mostly driven by an unwind in net working capital. Over the last 4 quarters, NWC has contributed ~$235mm to OMI’s cash flow. I don’t argue with the fact that OMI’s NWC was probably not run efficiently in the past, holding too much inventory and not collecting on A/R. However, it’s unrealistic to think that NWC can continue to be a source of cash in a business where you must hold adequate inventory on hand to be able to service customers promptly.

Valuation & Trade:

I am using ‘19A financials for my SOTP given I think it represents a good view of normalized, non-COVID earnings. I have tried to pro forma for the Movianto divestiture, stripping out its estimated EBITDA contribution from the Solutions business. Also, I am relying on my estimate of Byram EBITDA.

The valuation of a levered equity is inherently challenging and I don’t think anyone can be precise when ascribing a specific valuation. However, I am confident that OMI should be worth materially less than its market cap based on reasonable SOTP multiples and normalized earnings power. If I am wrong on higher sustainable earnings power, OMI already trades at ~14x P/E using management’s 2020 EPS guidance, above its 5 year average. I would note that their ‘20E EPS figure includes Q2’20 actual results, where the Global Products segment margin was 14%, higher than it has ever been in the last 4 years. Also, OMI trades at 8.5x EV/’20E EBITDA and 7.6x EV/’21E EBITDA using consensus numbers. These multiples are slightly higher than OMI’s long-term averages and Cardinal’s multiple, and are also based on an inflated EBITDA given the COVID related PPE earnings. I think the bull thesis for OMI has largely played out already, with future multiple expansion and/or sustainably higher earnings being unlikely.

Unfortunately, the thesis will take time to play out. As discussed, Global Solutions benefits from multi-year contracts that can take over a year to roll off once they lose a contract. If OMI were to get desperate, I suppose they could sell Byram as well. However, selling Byram at the top end of my SOTP range doesn’t clear the debt, and you are then left with a significantly worse business whose distribution economics would be readily apparent in the reported financials. I concede that stocks like these can be volatile over the short-term, and would advocate for both an outright short and using longer-term puts to implement the position. As stated earlier, I don’t advocate for a short position in the ’24 Notes. I believe that the Company will figure out a way to refinance the ‘24s ahead of the ’25 TLB maturity. The company does generate levered free cash flow today, and I don’t foresee liquidity being an issue.

Risks to Short Thesis:

1.  OMI is acquired: I don’t think an acquisition by Cardinal or Medline would pass anti-trust review. However, there has been industry chatter of McKesson or Henry Schein acquiring them. However, I don’t believe OMI and acute care distribution in general represents the likely area of growth for either company. Amazon has also been floated as a potential acquirer, but it seems like a low probability in my opinion

2.  Suppliers need OMI to survive: The thinking is that suppliers of medical products like J&J and Medtronic need OMI to survive because they are more likely to distribute their products than Medline / Cardinal. I understand the logic here, but I don’t envision a scenario where the suppliers would take any meaningful action to save OMI.

3.  We have reached a new normal of PPE demand: This is admittedly hard for me to ballpark. But, even if society were to require increased levels of PPE going forward, I would envision pricing / margins to eventually decrease on these items given supply would come on-line.

Conclusion:

Owens & Minor remains a structurally challenged business in a fiercely competitive industry. The management team has done a commendable job in stabilizing the business, alleviating concerns regarding a 2021 bankruptcy and capitalizing on COVID-related PPE demand. However, the business model has not been fundamentally changed or improved, and OMI is a slow melting ice cube that is not worth the $900mm+ market cap it currently enjoys. OMI shares represent an attractive short here, with a favorable risk-reward profile. Given the credit docs and thirst for yield, I do not advocate a short position in the ’24 Notes as the refinancing risk is too high in my opinion.

Catalyst

Slowdown in PPE demand related to COVID and/or additional PPE manufacturing supply coming on-line
Additional contract losses in Global Solutions